Simple Models of Operating Moral Hazard and Investing Moral Hazard

In this paper, we depict and analyze simple models of moral hazard, namely “operating moral hazard” and “investing moral hazard.” First we assume that a corporation exists primarily for the benefit of their shareholders. Then, moral hazard occurs when managers choose an option knowingly that is not optimum for shareholders. We evaluate the loss to shareholders in terms of cash flow to them in the long run. Operating moral hazard occurs when managers adopt a non-optimum operating strategy in day-to-day operations. This moral hazard was depicted in Ijiri and Lin (2006) using Markov processes. We will first examine the essence of this model as a basis for comparing with investing moral hazard. The two types of moral hazard are different in that loss to shareholders occur gradually and continuously in operating moral hazard (possibly allowing shareholders to react), while the loss occurs discretely and often in one-lump sum in investing moral hazard. In particular, we depict and analyze investing moral hazard using a model in a high tech industry called “planned obsolescence,” namely not obsolescence that naturally occurs but one that is induced by the seller of the equipment. In the final section, we will compare the two models to see some common elements between the two types of moral hazard, such as the larger losses to shareholders occurring in earlier periods before the dynamic system returns to its steady state.